TAXATION. Figure (1): Total Tax Burden in EU Member States 2011 and 2014 (in %of GDP)

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1 TAXATION The Annual Growth Survey identifies several categories of tax policy challenges currently faced by EU Member States. These tax policy challenges concern the potential of Member States for making their tax structure more growth-friendly as well as improving tax governance and the design of their taxes in their efficiency and fairness dimensions. More detailed information supporting the findings in this document can be found in the 2013 edition of the report "Tax Reforms in EU Member States" and previous editions of this report, published by the Commission services( 1 ). 1. More Growth-Friendly Tax Structures: tax shifts 1.1. The evolution of total tax burden in the European Union The total tax burden to GDP ratio includes all taxes and social security contribution receipts. The total tax burden varies widely across Member States, mostly reflecting variations in social preferences for government interventions. According to currently available estimates, this ratio will vary in 2014 from 26.9% in Lithuania to 48.9% in Denmark. Figure (1): Total Tax Burden in EU Member States 2011 and 2014 (in %of GDP) Source: European Commission Services data: Taxation Trends in the EU (2013) 2014 estimates: AMECO database - Autumn2013 forecast However, there is so far only partial evidence that the total level of taxation impacts on economic growth. There is nevertheless a better understanding of how individual components of the tax system affect growth through the channels of total factor productivity, the growth of capital stock and/or the growth of labour supply. Positive ( 1 ) Tax reforms in EU Member States 2013: Tax policy challenges for economic growth and fiscal stability. Taxation Papers 38 and European Economy See also Recent Reforms in Tax Systems in the EU: Good and Bad News Taxation Papers 39 Previous editions of the Tax Reforms report can be downloaded from the websites of DG TAXUD (Taxation Papers - European commission) and DG ECFIN (European Economy - European Commission) 1

2 outcomes can be achieved in two ways: by either providing the right incentives within the provisions of specific taxes or by shifting the tax structure in a desirable way Tax composition and growth There are differences across the EU not only in the overall tax level, but also in its composition. Member States raise various amounts of revenue from direct taxes, indirect taxes, and social security contributions. The new Member States, bar Malta (and, to a lesser extent, Cyprus), usually have a lower share of direct taxes in the total. In Denmark social security is mainly financed through direct taxes, which explains the particularly high contribution of direct taxes to total revenues. Figure (2): Structure of tax revenues by major type of taxes, 2014, % of the total forecasted tax burden. Source: European Commission Services (AMECO Autumn2013 forecast) Croatia: Shares are estimated taking into account 2012 information in the absence of full breakdown of estimated tax revenues for 2014 Taxes on corporate and personal income are usually seen as particularly detrimental to growth. Corporate income taxes affect the location of businesses and decrease domestic and foreign direct investment ( 2 ). In addition, statutory corporate income taxes affect profitshifting practices as multinationals tend to shift reported profits from high-taxed to lowtaxed countries. The tax levels, definition of the base and compliance aspects are all important factors in determining the effect of a corporate income tax. ( 2 ) Evidence on the link between corporate income taxes and location can be found in e.g. Barrios et al. (2012), "International Taxation and Multinational Firm Location Decisions", Journal of Public Economics. De Mooij and Ederveen (2008), "Corporate tax elasticities: a reader's guide to empirical findings," Oxford Review of Economic Policy, 24(4): found that a one-percentage point increase in the corporate tax burden reduces foreign direct investment by an average of 3.3%. 2

3 Figure (3): Corporate taxation Effective Average Tax Rates Source: ZEW (2012), Project for the European Commission Effective Tax Levels using the Devereux Griffith Methodology. Note: The EATR is a measure of the effect of tax on a nonmarginal investment. A non-marginal investment is one that not only covers all of its economic costs but also provides an economic or above-normal profit to the investor. So the EATR is a measure of the difference between pre-tax economic profit and post- (corporate) tax economic profit of the investor (definition taken and adapted from Australian Treasury Personal income taxes and social security contributions paid by employees affect the decisions of individuals about taking paid work and the number of hours they work, hence impacting labour supply. This is in particular true for some specific categories of workers such as low-income, married women and lone mothers ( 3 ). The tax burden on labour, in particular social security contributions paid by employers, also affects the cost of labour for employers and hence the demand for labour ( 4 ). Employment responses for specific groups and distributional effects depend on which income level taxes are levied. However, high taxes on labour are in general detrimental to growth (Figure 4). ( 3 ) See e.g. Meghir and Phillips (2010), "Labour Supply and Taxes", in IFS editor, The Mirrlees Review: Dimensions of Taxes, chapter 3, Oxford University Press. ( 4 ) Moreover, labour income taxes affect the absolute level of saving, and hence investment and the capital base of the economy. 3

4 Figure (4): Implicit tax rate on labour (ITR) % 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% BE IT AT FI SE CZ FR HU NL DE EE SI DK ES LV LU PL LT SK EL RO IE CY UK PT BG MT EU- EA Personal income tax Employees' SSC Employers' SSC and payroll taxes Source: European Commission 2013, Taxation Trends in the EU. (no data for HR) Note: The implicit tax rate on labour relates taxes collected from labour income to compensation of employees. Many Member States may want to achieve a reduction in corporate and/or labour income taxes in a budgetary-neutral way. Hence, they find a need to shift the tax burden to other tax bases. At the macroeconomic level, various studies ( 5 ) have indeed shown that taxes on income are usually associated with lower economic growth and that recurrent property taxes, consumption taxes and environmental taxes are the least detrimental to growth. Consumption taxes are less distortive than personal income taxes. That is because part of consumption is made from accumulated assets (e.g. savings, wealth), which are a relatively inelastic tax base. In terms of property taxes, an increase in recurrent taxes on immovable property is found to have the smallest effect on GDP per capita. Environmental taxes can help to internalise externalities and generate at the same time tax revenues. The potential room for a tax shift depends on the existing tax structure. High labour taxation together with a relatively low tax burden in one of the three areas: consumption taxes, recurrent property taxes or environmental taxes indicate room to shift taxes away from labour. Given the size of the tax base, which is relatively large for consumption taxes, but more limited for property taxation and environmental taxation, consumption taxes are largest in revenue terms. As a tax shift might also effect tax compliance, they should go hand in hand with measures to improve compliance, namely in the area of VAT. Note that a thematic document on the tax burden on labour is available at 2. Broadening of the tax bases As a general rule, tax expenditures and more general reductions of tax bases create economic distortions and lower the efficiency of the tax system. They increase compliance costs and lower tax collection without always achieving their original ( 5 ) See an in-depth discussion in European Commission (2010), Tax Reforms in the EU Member States, chapter 4. 4

5 economic or social objectives. Broadening the tax bases can thus reduce the complexity of the tax system, compliance costs and the costs of tax collection Tax expenditures Tax expenditures are widely used for personal income taxation and corporate tax purposes. For personal income taxes they come in the form of e.g. mortgage interest deductibility, commuter tax allowance. Figure (5) gives an overview of tax expenditures for those EU Member States, for which data is available ( 6 ). The figures point to high foregone tax revenues in some countries. Figure (5): Estimates of personal income tax expenditures in % of PIT collected Source: OECD (2010), Choosing a broad base low rate approach to Taxation, Paris, data taken from European Commission (2011) Note: Only available for eleven EU Member States. Tax expenditure estimates taken from the OECD refer to 2009 (Italy and Spain), 2008 (Germany, France and the Netherlands), financial year (UK), 2007 (Portugal), 2006 (Denmark, Austria and Greece) and 2005 (Belgium). Tax expenditures in corporate taxation have been introduced by a large number of Member States in terms of incentives on the base and to a lesser extent by reduced rates. Based on available information, a regular (partial or complete) assessment of tax expenditures (on labour and corporate) is carried out in about 2/3 of the Member States ( 7 ) The Debt bias In most corporate tax systems, interest payments on debt-financing are taxdeductible for corporate tax purposes while the return paid on equity-financing is not. This creates a bias in favour of debt that makes firms more fragile in case of ( 6 ) It is difficult to produce a clear definition of what tax expenditures are. They can take the form of allowances, exemptions, rate relief, tax deferral or credits and comparison across countries therefore needs to be taken with caution. ( 7 ) European Commission (2013). Tax Reforms in the EU Member States, page 57. 5

6 economic difficulties. A measure of this bias is the difference in the Effective Marginal Tax Rates (EMTR) between investments financed by debt and those financed by equity (retained earnings). The higher the difference denoted as debtbias in Figure 6 the higher the incentive for debt financing. In the majority of Member States, debt-financing even provides an implicit subsidy to investment (i.e. a negative EMTR). Figure (6): Debt-equity tax bias in Corporate Financing Note: EU is arithmetic average Source: ZEW (2012) 2.3. VAT reduced rates The economic literature ( 8 ) suggests that VAT should in general be levied to the extent possible on a broad base minimising revenue losses from exemptions and reduced rates. Deviation from uniformity is not the most efficient instrument to fulfil redistributive objectives and leads to economic costs (including compliance costs) and distortion, such as re-labelling activities (classifying the good as something different which is subject to a lower VAT rate). In practice, VAT is heterogeneously designed across Member States and reduced rates and exemptions are heavily used and differ strongly. The extensive use of reduced VAT rates leads to low actual revenue collection compared to a situation where all private consumption would be taxed at the standard rate and revenue effectively collected. Figure 7 shows the policy gap : the ratio of the revenue not collected due to the application of reduced rates and exemptions (disregarding non-compliance). ( 8 ) See e.g. Copenhagen Economics (2007), "Study on reduced VAT applied to goods and services in the Member States of the European Union", Taxation Papers 13. 6

7 Spain Poland United Kingdom Sweden Belgium Italy Malta Portugal France Netherlands Greece Ireland Germany Austria Denmark Finland Czech Republic Slovenia Latvia Hungary Slovakia Estonia Bulgaria Lithuania Luxembourg Romania EU-average Figure (7): VAT policy gap : Percentage of theoretical revenues at standard rates not collected due to reduced rates and exemptions ( ) 60% 50% 40% 30% 20% 10% 0% Source: CPB/CASE (2013): Study to quantify and analyse the VAT Gap in the EU-27 Member States -gap.pdf Figure 8 presents an estimate of VAT efficiency for the EU and other developed OECD countries. New Zealand, Switzerland and Japan reach a higher revenue ratio than the EU, which is explained by the fact that these OECD countries rely on VAT rate differentiation to a lesser extent than EU Member States. Figure (8): VAT collection to theoretical revenues EU and selected OECD (2011) 1,2 1 0,8 0,6 0,4 0,2 0 NZ CH JP NO AU CA EU Note: 2009 for non-eu and 2010 for EU. EU is GDP-weighted average. Source: European Commission (Taxation Trends 2013) and OECD (2013), Assessment and recommendations, in OECD Economic Surveys: Italy 2013, OECD Publishing. NB: there is no VAT in the USA 3. Better design of individual taxes 3.1. Housing taxation Incentives towards debt-financing also exist in housing taxation as many Member States allow a rather substantial deductibility of interest payments on mortgages. This provides incentives for investors to take debt to invest in immovable properties and can contribute in combination with no or weak taxation of imputed rents to an overinvestment in immovable property to the detriment of other productive investment. 7

8 UK BE FR DK IT ES EL PL LU IE FI NL HU PT MT SE LV DE RO CY SI BG CZ AT LT SK EE EU-27 Property taxes, and in particular recurrent taxes on immovable property, are among the taxes least detrimental to growth. Taxes on immovable property or housing take various forms and include both recurrent and transaction taxes. Housing transaction taxes tend to discourage transactions, efficient allocation of properties and labour mobility. Recurrent taxes on real estate and land are characterised by a stable and relatively immobile and visible tax base, which is hence more difficult to evade and induces less economic distortions. Current systems for taxing immovable property that rely heavily on transaction taxes provide scope for improving tax design. A shift from taxes on transactions to recurrent taxes on real estate would reduce the distortions introduced by taxation and improve economic efficiency. It is important in addition that recurrent taxes are based on accurate and updated values for the tax base as many housing values are based on out-dated data( 9 ). Figure (9): Revenues from property taxes in 2011 (in % of GDP) 4,5 4 3,5 3 2,5 2 1,5 1 0,5 0 Recurrent taxes on immovable property Other taxes Note: "Other taxes on property" include taxes on net wealth, inheritance, gifts and other property items as well as financial and capital transactions. Data does not include PIT on imputed rents. Source: European Commission; Taxation Trends in the EU Environmentally-friendly taxation Environmental taxes remain underdeveloped in many Member States and their revenues in percentage of GDP declined during the period , despite efforts to move to a greener society. Revenues have however increased in and There is potential to raise revenue through tax increases as well as through reducing tax expenditure in environmental taxation. ( 9 ) Property tax on market values are however not as stable as property tax on (updated) cadastral values. 8

9 % GDP Figure (10): Environmental Tax Revenue across Member States, 2011, % of GDP 4,5 4 3,5 3 2,5 2 1,5 1 0,5 0 DK SI FI BG IT UK PL SE AT PT DE RO FR ES EU Source: European Commission Taxation Trends Report 2013 edition Generally, environmentally-friendly taxation would also greatly benefit from the adoption by Member States of the revised Energy Taxation Directive (ETD), which aims to restructure the way in which energy is taxed to support the objective of moving to a low-carbon and energy-efficient economy, and to avoid problems for the Internal Market. 4. Tax compliance Europe continues to face the challenge of revenue losses due to tax fraud, tax evasion, and other practices which hinder tax bases or decrease tax liability by illegal means. Moreover, there is growing consensus that also such practices as aggressive tax planning, despite being strictly speaking legal, lead to significant erosion of tax bases. Tackling these practices is necessary not only to make sure that Member States regain revenues lost to fraudsters but also so that everyone pay their fair share. This is particularly important in times of fiscal consolidation. In addition, tax evasion and tax fraud create distortions which can hinder the functioning of the internal market. It is challenging to estimate revenue losses due to tax noncompliance. A recent study prepared for the European Commission shows that the VAT "compliance gap", that is, VAT revenue forgone due to non-compliance, was as high as EUR 193 billion in 2011, ca. 1.5% of GDP (Figure 11). One shall note however that this amount is not entirely due to fraud as part of the gap can also be due to statistical errors or legitimate situations of non-payment such as bankruptcies. Member States keep focussing efforts to improve tax compliance by a multipronged approach which include fighting against tax fraud and tax evasion, tackling aggressive tax planning and tax havens, making tax administrations more efficient and taking tax simplification measures. At the EU level, in particular, Member States have the possibility exploit to their fullest available tools to fight tax fraud and tax evasion more effectively through administrative cooperation and enhanced automatic exchange of information. 9

10 SK PL DE PT BE BG CZ CY FR IE HU MT IT LT NL SI RO ES LU UK FI DK LV AT SE EE EA EU Romania Greece Latvia Lithuania Slovakia Hungary Czech Rep Italy Estonia Bulgaria France Portugal Finland Poland EU-26 total Spain Belgium Luxembourg Austria Denmark United Germany Slovenia Ireland Netherlands Malta Sweden.Figure (11): VAT "compliance" gap as a percentage of GDP, Source: CPB/CASE (2013): Study to quantify and analyse the VAT Gap in the EU-27 Member States -gap.pdf Finally, tax authorities should also aim at minimising the administrative costs of collecting taxes for the government (collection costs) and of paying taxes for taxpayers, i.e. businesses and individuals (compliance costs). Figure (12): Administrative cost for tax administrations per net revenue collection (cost per 100 units of revenue), ,5 3 2,5 2 1,5 1 0,5 0 Source: OECD: Tax Administration 2013 Comparative information on OECD and other advanced and emerging economies. No data available for Greece. EU and EA averages refer to Redistribution The relationship between income inequality and economic growth is complex. To address inequalities, countries typically use their tax and benefit systems. The most commonly used instruments are progressivity of personal income taxes, targeted tax schemes for low-income households, as well as various social programmes either inkind or monetary. The degree of redistribution of the tax and benefits systems varies 10

11 however widely across Member States and striking the right balance between social equity and economic efficiency is a national prerogative, which depends on national preferences. The distribution of market income, obtained either from labour or capital, is a prior determinant of the distribution of household (final) disposable income. The more unequal the market income, the greater the amount of redistribution required to achieve a given degree of equality in disposable income. Figure (13): Gini coefficient for disposable income in 2012 and change of market income and disposable income inequalities between 2007 and 2012 ( 10 ) Note: Data cover the entire population. Income data are adjusted for household size (equivalation). Source: Eurostat and OECD.* Eurostat, 2011 for BE, IE, AT, UK, IE and HU; ** OECD, unavailable for BG, CY, HR, MT, LT, LV, RO The bars in Figure 13 show the Gini coefficients, a widely used indicator of inequality ( 11 ), for disposable incomes in EU Member States in 2012, as reported by Eurostat OECD data demonstrate that the average Gini-coefficient for market income is significantly higher than for disposable income for EU countries with available OECD data. The fact that disposable income inequality grew on average much less than market income inequality between 2007 and 2010 (see squares and triangles in Figure (13) shows how tax and benefit system were able to mitigate the effect of the crisis on the growth of inequality. Joumard, Pisu and Bloch (2012) 12 identify two types of tax reforms according to the presence or absence of a trade-off between equity and efficiency. The first type refers to tax reforms that are both growth-friendly and are likely to reduce inequality. ( 10 ) Market incomes are gross wages, income from self-employment, capital income, and returns from savings. Disposable income is market income plus social transfers less income taxes. Social transfers include all social transfers received in cash including old-age pensions. ( 11 ) The Gini-coefficient is the most used inequality measure. It varies between 0, when everyone receives an identical amount of income, and 1, when a single individual receives all the income. Higher values of the Gini-coefficient thus indicate higher inequality in the income distribution. ( 12 ) Joumard, Pisu and Bloch (2012), «Less Income Inequality and More Growth are they compatible? Part 3. Income Redistribution via Taxes and Transfers across OECD countries», Economics Department Working Paper,

12 Examples include tax expenditures that mainly benefit high-income taxpayers because they can deduct against a higher tax rate, tax breaks on stock-options, bonuses and carried interest, or low capital gains taxes. The second type of tax reforms found by Joumard et al (2012) are those likely to be growth-friendly but that lead to an increase in inequality. Reshaping the tax structure to less growth-distortive taxes in particular away from labour and corporate income taxes towards consumption would improve incentives to work, save and invest, but could be regressive. Tax reforms or direct transfers targeted to lower income groups can be used to alleviate or even eliminate this trade off. Another important issue linked to a growth-friendly tax shift is the role of combating fraud and tax evasion. Tax evasion affects negatively the level of inequality and poverty. In this context, measures which prevent or limit the reduction of a tax base by tax fraud and evasion might bring double benefit as they might positively impact on both fiscal consolidation efforts and financing of social transfers while decreasing the burden on tax payers willing to comply. 12